Thursday, July 12, 2012

"This time it's different": China edition

I confess: I take a guilty pleasure in reading articles that claim "This time it's different". Back in 2004-5, when I started reading financial and economics news, all of those yarns were about how U.S. housing prices had reached a permanently high plateau, or how the financial system had evolved to be able to spread risks to the people most willing to bear them, etc. etc. It was fun. Everyone seemed to know it was BS. We just sat there imagining who would possibly believe it.

Anyway, the fun is back. As China slips into a slowdown, a few people are piping up to claim that no, this time it's different, China has it all figured out, their culture is different, their government is better, and so forth. But so far, I haven't seen anyone do this routine as beautifully as James White, analyst at Colonial First State. In an article flagged by Izabella Kaminska of FT Alphaville, he writes:

China’s rise confounds economic history, but not necessarily economic theory...[its] foundations seem brittle to western investors used to judging the health of an economy through the returns on capital. But the Chinese are comfortable with low capital returns if the pay-off is a stronger economy. This has been the case...

The Chinese don’t play chess. They play wei qi [also known as Go]...The Chinese government views the economy as though it’s wei qi. Each piece has its own role in the economy, but each is no more important than another.

This is an important observation. In the developed world...Falling or negative returns on capital are a sure sign of economic weakness reflecting the end of a period of over-investment...In China, capital is just one piece on the board where the aim is to raise living standards of all households...The government’s role is paramount. Despite claims of dramatic imbalances (investment spending has made up to 45% of GDP in recent years, compared to below 15% in some developed economies), investment is driving sustainably higher economic growth...

At a macro-level, the higher allocation of capital in China has led to falling profit growth and lower returns for capital...Since 2004...China['s stock market] is up just 46%...2011 has been punctuated with stories of large capital losses across the economy...

By not using capital returns as a scorecard for economic progress, China improves the allocation of capital in its economy and raises living standards. Effectively, China takes a broader perspective to the value of capital in an economy...

First, and most obviously, the government has the ability to fund losses on individual capital projects through the accumulated financial reserves, totalling at least $3.2 trillion. Second, and most importantly, the Chinese government, as ultimate capital allocator, can recoup returns from projects by capturing the positive externalities from projects in the form of higher tax revenues created by higher levels of activity...

China’s economic performance in the last 20 years has been remarkable; very strong growth and low inflation...The government, as the largest capital allocator, can both manage losses from individual projects and capture the benefits of loss-making projects through its taxcollecting authorities.

I love this. It has all the classic hallmarks of a "This time it's different" piece. First - and this is my personal favorite - we have the cultural analogy. Chinese people don't play chess, they play Go! And by realizing this we can understand why low capital returns are irrelevant! It's all about the Eastern Mystique...this time it's different because these people are different.

(Of course, an astute reader might point out that Japanese people also play Go, and until the last couple of decades absolutely dominated international Go competitions. That didn't prevent the Japanese economy from tanking, and it didn't change the fact that wasteful investment was a central feature of said tanking.)

Next we have the faith in the government. China's government, we are told, is a benevolent sort of oligarchy, whose "aim is to raise living standards of all households". Never mind the massive corruption and state-corporate collusion. Never mind the negative real rates of return on Chinese household deposits. Never mind China's slow consumption growth and low share of household consumption in GDP. Never mind the Latin America-like levels of inequality. China's government, unlike our Western variety, is all for The People, despite the curious fact that The People there have less say in the government's operations. (Note how this also plays to Orientalist stereotypes: the Chinese as a Confucianist hive mind.)

But the Chinese government isn't just benevolent, it's omnipotent! The government can bail out loss-making capital projects with its massive stock of foreign asset reserves. Never mind the fact that the government acquired those reserves from private banks by swapping government liabilities for foreign assets.

Finally we have the blatant trend extrapolation. China has grown strongly for the last 20 years; hence it will continue to grow strongly. It's growth is "sustainably higher" than that of other countries. If you bet against China in 2001, you were a sucker; hence, if you bet against China now, you are a sucker.

So because China's government cares more about the general populace than about the profits of capitalists, which somehow has to do with the fact that they play Go instead of chess, it will use its foreign asset reserves to bail out loss-making projects that produce positive externalities that raise GDP growth overall. Hence, "This time it's different", and we should view the 20-year trend of Chinese growth as something structural instead of the kind of transitory catch-up phase observed in every other country in history, including Japan, South Korea, and Taiwan. Therefore, the market's expectation that growth will slow - reflected in the only-46% rise in Chinese stocks since 2004 - is seriously wrong.

Got it.

Anyway, fun-poking aside, I have always been struck by the sheer volume of words expended on the question of whether newly industrializing economies will break the Solow Model or not. Really, it's very hard to see how you can break the Solow Model - keep accumulating capital, and your growth will be fast but steadily decreasing as you converge to the rich-world average. Sure, you can fall short of the Solow Model and get stuck in a "middle income trap". Sure, there are questions as to how fast technology can be transferred from richer countries, or whether investment has a maximum "speed" beyond which it becomes more wasteful, or what kind of institutions are optimal. But the idea that growth must slow - gently or otherwise - as a country gets richer should, in my opinion, be the jumping-off point for any predictions about development.

It's very weird that after all these years, we're still trying to extrapolate countries' futures based on what kind of board games they play.

But far more interesting is a Chinese company's takeover of Hawker Beechcraft, a small 'personal' aircraft manufacturer in Kansas. It highlights all that is wrong with 'vulture capital', ooops venture capital. Jim Fallows has the details here: http://www.theatlantic.com/politics/archive/2012/07/chronicles-of-casino-capitalism-kicking-off-a-series/259772/

And guess which US venture firm is owed money as part of this deal? Hint: it's linked to a current presidential aspirant. Too sad really.

Private Equity is about using leveraged buyouts to buy pre-existing companies, often taking publicly traded companies private (I'll leave it up to you do figure out what sort of advantages taking a public company private confers on the private equity management team).

Maybe, but some things are probably just a historical accident. Maybe the game was created by chance and just caught on. Chess is an import to the west and in an alternative universe maybe Go got imported and found favour instead. Check again in 10 000 years when the relevance of these starting points has dropped to zero.

Interestingly, China, in all of its history, has never had a recession in quite the same way the Western world has encountered economic fluctuations and speculative euphoria. Adam Smith's "prodigals and projectors" and J.M. Keynes's "speculators and rentiers" illustrate the latter phenomenon perfectly. It had periods of economic progress that tended to end via wars. Should there be contraction in China, I hope it isn't as crippling as the worst-case scenario might depict.

P.S. Noah Smith, have you read An Inquiry into the Nature and Causes of the Wealth of Nations?

Interestingly, China, in all of its history, has never had a recession in quite the same way the Western world has encountered economic fluctuations and speculative euphoria.

Actually, a quick Google says that this is not true! According to this, the Shanghai Stock Exchange had a bubble and crash in 1871, another in 1883, and possibly a third in 1890:http://en.wikipedia.org/wiki/Shanghai_Stock_Exchange

The crash in 1883 appears to have been related to a real estate bubble:http://www.dsecurity.info/6510.html

The first recorded speculative manias and crashes recorded in the West were the Dutch Tulip Mania in the 1600s and the South Sea Bubble in the 1700s. The Qing Dynasty probably didn't have asset markets at that time, so we don't have good data on what kind of bubbles existed during those centuries. Before that, bubbles may have happened, but we don't have good data about them in the West or in China.

Before the Qing period, I'd be very surprised if China experienced recessions of the modern type, simply because most of the economy was farming; with farming, you get recessions when there are bad harvests. The same was true in the West. Investment was very very low, so you didn't see the kind of fluctuations in investment that characterize modern recessions.

Yes, famine does have economic consequences. I don't deny that. But as for the Shanghai Stock Exchange encountering speculative euphoria in the 19th century, Shanghai was under European control. It was under European control. You could make the argument it technically wasn't under Chinese hands at the time. :-P

So basically, your claim that Chinese bubbles/recessions are different can't really be proven one way or the other. First China was agrarian, with bad or no economic data...then it was under European control...then it was mostly at war. The only applicable period is 1979-present. That's not a very good "all of history" sample.

Since 1979, China had a recession after Tiananmen (political shock). It might have had a recession in 1997; the data showed only a moderate slowdown, but they may have been fudged.

So basically, this "China is different and doesn't have normal recessions" idea is just a conjecture at this point. My bet is that China is perfectly normal, and will experience bubbles and busts just like every other country.

But even if I'm wrong, I bet that China's trend growth will now slow from 10% to maybe 7%. Even the Emperor must bow to Bob Solow! ;)

Notice the tongue emoticon, Noah...I was being facetious. I know that there were periods of great inflation in Chinese history. I'm not saying that this time is different for China, I'm just stating an observation from my knowledge of Chinese history.

Thanks for doing your part on dispelling the Chinese mystique. I live and work in China and before that worked in Panama and Brazil. My own perspective is that much of what is often highlighted as profound cultural or political differences between China and whoever are actually most easily explained by simple economics.

China compared to the developed world is still a poor country, with only 60% of Mexico's GDP per capita. While it has experienced rapid growth in the past 15 years this is similar to other countries that have managed to escape the poverty trap. This rapid movement from being very poor to being middle income poor means much of what you would expect to see in a por society is still prevalent in China: entrenched superstitions (especially about health), reliance on extra-legal mechanisms for contract enforcement and business expansion, and heavy reliance on relationships and connections.

Certainly there are unique features about China such as an entrenched one-party system that controls through state owned enterprises somewhere between 60 to 80% of the economy. But these factors are still not much about culture or some difference about Chinese people.

Btw, I don't think I have seen a single game Go being played in China. The most popular games typically involve betting such as Mah Jong and a card game called "Struggle Against the Landlord."

Yes, it is quite common to see older men playing Chinese chess (which is not at all related to go) in the parks. It probably has the same level of popularity as western chess does in the US, which is to say a small but loyal following. It is not a game for the masses and is fading in popularity. Not one of my Chinese employees (all college educated) know the rules well enough to play.

Noah, next time you are in China let me know. Would love to share a bottle of Bai Jiao with you.

Personally I love journalists' habits of starting any piece about the far east with a highly cheesy culture reference (I forget who the Economist's Japan guy is, but he really is good at that). However I'm not sure there's anything wrong with the basic proposition that the Chinese government will initiate potentially wasteful investment if they believe that long-term it will lead to positive outcomes (for whatever reason). The proposition that government should have a very high risk tolerance to wasted capital is at the heart of most economic theory since Keynes onwards (and probably before). A non-democratic country with a low level of government accountability arguably has a higher risk tolerance still because it's not going to get chastised for having wasted dollars once the dust has settled.

To see the argument another way, China hasa) a massive investment poolb) very low GDP per personSo it would seem strange and even slightly callous if they were just sitting on their funds whilst their citizens went without modern toilets because they couldn't be sure of allocating them to projects which produced a directly measurable positive return. If I was in their shoes then I would probably want to throw a lot of money into the economy and see what happened - after all the externalities for these things (particularly in a rapidly developing economy) are very hard to foresee and could be highly positive.

This is obviously not to say that it's a great idea to invest your capital in the so-called "post-capital economy", just that for the time being their growth can be sustained. The Solow point still stands as completely correct - without any of the trappings of a modern economy (good legal system, free markets etcetera) I'd be very surprised if China even gets as far as the middle income trap, let alone approaches developed world GDP per head. But I would argue that the guy's interpretation of Chinese government's logic is correct.

China is suffering from over investment and insufficient domestic demand. This is not a secret to the Chinese. The most recent 5 year plan makes restructuring the economy a top priority. (Nice of the outgoing leadership to punt this to the new guys.)

Yet it is exactly the nature of China's command economy and one party rule that makes such a change so difficult. Party members whether they be government officials, heads of state owned enterprises, or bank managers, rely on government programs for their wealth. And in recent years many instituions including municipalities have grown to depend on them for solvency.

It is not surprising that China politically has a far easier time practicing Keynesian policies. It is not necessarily because the policy makers are any smarter (even though I would say many of them actually are), it is that they have a direct self interest.

The two questions to ask are how much more can China grow by inefficiently investing while resorting to financial repression to pay for it? And how to break the cycle when this dog stops hunting with out having banks, local governments, SOEs and the party itself come crashing down?

Yes, I think your analysis is very reasonable. That financial repression point is particularly pertinent. Falling inflation means that SOE borrowing rates are becoming more expensive, which could be what causes the sh*t to hit the fan.

"Yet it is exactly the nature of China's command economy and one party rule that makes such a change so difficult. "

Really? Seems far easier in China's command economy and one-party system than it is the US's economy and two-party system.

One of the things is, in China's command economy, the elite *can* (I don't know if they *will*) restructure the economy while still keeping their own lives relatively cozy.

In the US economy, we have psychopaths in the elite who will not be satisfied with merely being set for life and having a couple of mansions; they have to have MORE MORE MORE MORE forever. Therefore they refuse to restructure the economy while keeping their own lives relatively cozy, because they can't stand the concept of merely being relatively cozy.

If China has *THAT* problem, they're screwed. But I think they don't. If they have an elite who is content to merely be rich and powerful, rather than demanding MORE MORE MORE, they can simply restructure the economy and win.

"without any of the trappings of a modern economy (good legal system, free markets etcetera) I'd be very surprised if China even gets as far as the middle income trap,"

The US doesn't have a good legal system any more. Does this mean that we're going to drop out of the high-GDP economies? Maybe we already have.

Actually, by all accounts China's legal system is pretty much as good as the US's. This is not a compliment to the US. But remember that China has a *very* long legal tradition, being in fact the inventor of what is now known as "Legalism".

China is a managed economy. Most of the entities potentially at risk of failure, banks, state-owned enterprises, have explicit state backing. The state has the levers to short-circuit cascading failures, a debt-deflation cycle. The leadership has a strong incentive to get it right, if they screw up they get replaced, or arrested.

People are not that highly levered or overextended. If the government provided a bigger safety net so people didn't feel the need to save so much, and less financial repression so funds could flow to better uses, a lot of demand and productive investment could be unleashed.

China is the proverbial elephant on a bicycle…as long as the wheels keep spinning all seems well, but when there is trouble it will be a very big mess.

But actually they've kept the wheel spinning for a long time, including through the financial crisis. So I kind of think the burden is on those who think the crash is upon us to show why this time is different from all the other times people predicted a hard landing.

When I was doing my MBA in the early 1990s we had similar discussions about Japan and the "Asian tigers" - why were they doing so well, was this the end of Western economic dominance? There was an assumption that their success was due to intrinsic cultural factors, and that the West needed to adopt practices from their cultures if it wished to survive. There were whole seminars on "Japanese business" - not just how to do business WITH Japanese, but how to do business LIKE Japanese. There was also a belief that their success would never end.....

Cue the Asian crisis of 1997. Yes, the Asian tigers recovered, but Japan, which was the dominant economy in the East, has had 20 years of stagnation. Why do we NEVER learn? China's growth is a bubble and the signs are already there that it will burst. We should be preparing for the consequences.

Entertaining post, but one of the things I have been noticing over the years is that any opinion on economics that includes the premise that Japan's economy has "tanked" is likely to be full of observations that are half-truths at best. It is true that Japan's economy is not the juggernaut that it once seemed, but by almost any measure, it still is more successful, and on a more sound basis than any economy in the West.

Did you reach a conclusion with this piece? Citing some model about development is nice, and this time is different is always eye opening. But what is your point?

Using a western lens to examine china always seemed problematic to me. I mean....when did they get any property rights, like 1998? You think comparing that market to any other housing market is really warranted?

"It's very weird that after all these years, we're still trying to extrapolate countries' futures based on what kind of board games they play."

Whoever said economics was an exact science?

China has massive problems — mostly (in my view) the misallocation of capital via graft, poor central planning and animal spirits. That's fine; plenty of countries both capitalist and non-capitalist have gone through phases of very extreme capital misallocation and emerged the other side the better. But the breakdown is painful. And by running massive trade deficits with China, and being dependent on many products and components they export (e.g. rare earths) the West has opened up a huge gulf of volatility.

Yeah. While sometimes gut hunches, intuition and prejudices make one look incredibly smart, most of the time,not at all. People have to be careful in speaking from their gut or reaching snap judgments over board games, or culture, or television. Breaking Bad may one day convince many Europeans that all Americans are meth heads.

Japan seems like an extraordinarily creative place, although strangely I've been playing a lot more Western videogames in recent years; where once Grandia, now Fallout 3. Apparently it's hard to get food there that isn't excessively salty/MSG-y. I don't know, I've never been.

...because most of the economy was farming; with farming, you get recessions when there are bad harvests. The same was true in the West.

I like this-The Weather was "The Decider"-individuals weren't dependent on the "weather" of humans. The Amish in me liked that. Thanks!

Another thing that's worth noting is that in the 1930's FDR was often talking about "the price level" and it was very effective communication and made sense at the time because most of the people were FARMERS at that time and most importantly they were PRODUCERS of "stuff' that they had to sell. Nowadays, when you talk about NGDP targeting or price level targeting you are talking to a lot of hands in many ways. We have become a nation of RENTIERS. Hmmm, what do we do when we are mostly rentiers to pull us out of the hole we're in?

I don't know what the Solow Model is, but it's clear what the escape valve is: after building your booming industrial economy based on bubbles, when the crash starts, you promptly implement socialism, 100% tax rates on the rich, direct cash transfers to the poor.

This is how England avoided revolution; by installing the Labour Party after WWII. They had done much the same thing for previous bubbles; after each massive bust, left-wing redistributionist parties got into power and alleviated the social problems.

Will the Chinese government do the same? No idea. It's a question of their political entanglements. I think their current master of the economy is willing to do so, but I don't know if the power structure around him will allow him to implement actual Communist policies all of a sudden.